The great trade collapse during the global crisis has reignited interest in the relationship between trade and GDP over the business cycle. This column argues that trade patterns in the recent recession largely reflected the shift away from demand for durable goods, although increasing trade frictions did play a moderate role in some countries.

As discussed by dozens of researchers in a recently released Vox eBook (Baldwin 2009), myriad factors may have contributed to the changes in the ratio of trade to GDP in countries across the globe. In the eBook, Bergsten writes on the role of deficits and external imbalances. Levchenko, Lewis, and Tesar highlight a disproportionate decline in durable goods sectors, those most important to trade. Evenett reviews protectionist measures linked to the crisis. Our research (Eaton et al. 2010) creates a model in which demand shocks, trade friction shocks (very broadly defined), productivity or preference shocks, and changes in deficits can all play some role in driving global trade patterns. Further, our general equilibrium model allows us to run counterfactuals which quantify the contribution of each factor in isolation.

The model builds on the work of Eaton and Kortum (2002), Alvarez and Lucas (2007), and Deckle et al. (2008). Given the importance of heterogeneity in inter-sectoral linkages, production in our model reflects the country-specific input-output structures found in OECD input-output tables. We merge this structure with a gravity model of trade to ensure that we can actually match the large changes in bilateral trade shares observed during the crisis. Finally, we use information contained in monthly sector-level industrial production and producer price indices to generate monthly production series for more than 20 countries. Combined with monthly information on trade, these data allow us to focus on the key inflection points marking the beginning and end of the recent downturn.

We find that the importance of each shock varies across trading relationships and countries. For example, increases in trade frictions played only a modest role, if any, in most countries. China and Japan, however, experienced increases in trade frictions which, on their own, reduced global trade/GDP by several percentage points. Figure 1 shows the time fixed effects from a regression of Japan's bilateral Head-Ries indices, inverse measures of trade frictions, from the first quarter of 1997 to the fourth quarter of 2009. The decrease in the index in 2008 suggests that trade fell relative to what would be expected just from demand, productivity, or deficit shocks alone. This decline could reflect, for example, difficulties in financing trade as in Amiti and Weinstein (2009), the home-bias implicit in fiscal stimulus, or protectionist measures, among other possibilities.

Figure 1. Durable and non-durable trade frictions in Japan
The decline in the share of the durable sectors in final demand, however, was most striking. This negative durables demand shock exceeded 20% for most countries. See, for example, the sharp decline in durables’ share for the US and South Korea in Figure 2 below.

Figure 2. Durable and non-durable shares in final demand for the US and South Korea
When we run our model in the counterfactual scenario in which we only allow for demand shocks, and hold fixed deficits, trade frictions, and productivities or preferences, we explain more than 80% of the change in global trade/GDP and nearly two-thirds of the cross-country pattern of changes in trade/GDP.

The recent recession perhaps is the most interesting post-war application of our framework, but in future work we intend to use it to decompose trade changes over longer periods of time, in particular during other recessions. While this note focuses on the ratio of trade to GDP, future work will investigate the implications of the model for production, GDP, and other macroeconomic variables.